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Interview with Russell Napier

LESLIE P. NORTON, Barron’s

Russell Napier, an independent strategist and market historian, likes to challenge investors’ comfortable assumptions. Based in Edinburgh, Scotland, he spent two decades as an equity-market and global-macro strategist at CLSA, the Asian brokerage, and now publishes a global macroeconomic and strategy report, “The Solid Ground,” on ERIC, an online platform he cofounded for investment research. He also created the Library of Mistakes, a financial-history library in Edinburgh, that he plans to replicate at universities around the world.

Napier has been bearish since 2011 on equities and commodities, and expects deflation to hit developed markets. He recently shared with Barron’s his views on the coming Brexit referendum, China’s currency, and today’s financial mistakes.

Barron’s: Britain will vote on June 23 on whether to leave the European Union. How do you expect the so-called Brexit vote to go?

Napier: It is too tight to call. The most important thing is that the move to a federal Europe is a massive constitutional change, which at some stage will need to be endorsed by the people of each sovereign state, usually by referendum. It is silly to believe this issue is just a United Kingdom thing. Look at polls all over Europe. People are voting for anybody who, whether on the extreme left or right, wants to maintain the sovereignty of that particular state within the European Union. That is completely contrary to the ability to have a functioning euro.

This is round one. The most important referendums will be those in the euro countries. I expect referendums in places like Finland, the Netherlands, and even Italy. European legislation is forcing Italy into a form of bank recapitalization, which won’t work and is bad for the Italian economy. Italy will move up the agenda quickly.

If the U.K. votes to leave, will Scotland push for independence again?

If Scotland votes to stay in and England votes to leave, there might be another referendum on Scottish independence. The problem would be that Scotland voted for something different previously, when it said it would continue to use sterling and wouldn’t have a border. If the rest of the U.K. is out of the EU, and Scotland wants to stay in, there would have to be a border. It would be difficult for Scotland to use sterling. If Scotland voted against independence last time, the Scots would really vote against it again. The shock and dislocation of having a border and passports, of not having sterling, are so big.

With several potential votes ahead, what is the outlook for markets?

The most important thing for investors would be exchange controls. If a member of the euro zone had a referendum on leaving the EU, temporary capital controls to protect financial stability would be politically justifiable. The dislocation associated with the speculation around the referendum would be huge. Provisions in the European treaties allow exchange controls under extreme circumstances.

The bigger picture is that open-end funds are facing greater illiquidity in their underlying instruments. There are $37 trillion of assets in open-end funds globally. Will politicians put up barriers to the free movement of capital, which would paralyze sections of the financial-services industry?

You recently wrote a report on policy singularity. What does that mean?

I invented the phrase to refer to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in [former Federal Reserve Chairman Ben] Bernanke’s famous helicopter speech. Briefly, the steps [taken by the Fed] included quantitative easing; effectively pegging the yield curve; providing forward [rate-hike] guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money. [In a 2002 speech referring to the possibility of monetary-financed tax cuts, Bernanke referenced the late economist Milton Friedman’s assertion that a central bank could create inflation and economic growth by dropping money from the sky.]

Once the central bank runs out of ammunition, it turns to the government. In Japan, there will be open ears. If we all woke up one morning and every major developed nation undertook policy singularity, you’d have to believe in growth, inflation, and reflation. But if one country does it unilaterally, like Japan, what you’d get is a precipitous decline in the yen. While the Fed is struggling to create money and the Europeans aren’t creating any, the Japanese central bank/government can create as much as it likes. That would imply dislocations for China, Germany, and other markets. It could put a lot of countries in trouble.

How would helicopter money manifest in Japan?

It wouldn’t be about building more roads and bridges, but about [boosting] consumption. It would be along the lines of the government announcing that everyone in Japan with a child under 10 will live tax-free. The instant ramification would be much higher forecasts for the fiscal deficit, which would be funded by the central bank printing money. This puts money in the hands of people who might consume—people with children under age 10.

Did you know that Japan has a ministry for population growth, whose job is to drive the birth rate higher? Japan has tried everything else. If they have to go to the final step, they are prepared for it. I would be confident forecasting that the yen will be lower than 130 to the dollar within 12 months. [It was 105 last week.]

What other countries will adopt policy singularity?

Helicopter money is a long way off in the U.S. When it does come, it would be for building roads and bridges. In Europe, I can’t see how the banking system is robust enough to translate European Central Bank monetary policy into expanding balance sheets with more credit and more money. When the politicians are aligned with the central bankers, that is the end of independent central banking. It begins in Japan but it will spread.

You famously predicted the Chinese yuan will fall 20%. Lately it has held steady against the yen. What happens if the yen falls, as you expect?

The yuan’s price is the most political price in finance. China’s monetary response to economic slowing is constrained by its exchange-rate policy. If credit and monetary-policy growth rise to the levels required to sustain China’s debt-fueled growth, then the exchange-rate target can’t be sustained. If money growth rises to historical highs, it is reasonable to expect an exchange-rate adjustment of 20% or more. A fall in the yen is the perfect cover story. China could say, “Look, what do you expect us to do?” If the yen started falling, the yuan would follow, though not until after the U.S. presidential election. They would be too worried it would produce a Trump presidency.

What will the Fed do next?

The Fed’s hesitation to move interest rates higher reflects their understanding about the fragility of the global monetary system. On the national-income and product-account data, corporate profits are weak. Capex [capital spending] is beginning to slow, not that it was ever robust. Then you had that jobs number [the U.S. created just 38,000 jobs in May]. It is exceedingly worrying if you begin that slowdown process with interest rates close to zero.

I am not saying [Fed chief] Janet Yellen is completely out of bullets. She’s not in the same place as Japan or the ECB. But she has long conversations with [International Monetary Fund chief] Christine Lagarde, who has been warning everyone how fragile the global system is. She sees real distress in commodity producers. Yellen hasn’t been more aggressive in raising rates for reasons including China and Brexit. And [Japan’s Prime Minister Shinzo] Abe told the G7 that the world was on the verge of another Lehman Brothers crisis. Any interest-rate increase is more likely to be in 2018 than 2016.

As the author of the book Anatomy of the Bear, you have some expertise in forecasting the stock market. What do you predict?

In a world where there is growth and inflation remains between zero and 4%, you get high valuations for equities. The current cyclically adjusted P/E ratio of 26 is high, but not exceedingly high. It could go even higher. The most damaging and dangerous thing for the equity market is deflation, because it means falling cash flows; if you have a lot of debt and can’t pay it, equity gets wiped out. Deflation often comes with credit distress. The market falls quickly, whether in 2007-2008, 1928-1929, or 1919-1921.

The market remains high today, but I see global growth falling and trade looking bad. We might slump to a recession with deflation. Markets move quickly when there is a credit distress because assets disappear. We saw that with Lehman. In the past two years, many borrowers have been in distress globally. I have long thought emerging-market debtors are the weak link, because they were borrowing in someone else’s currency. I still believe the stock market has to go below its March 2009 levels.

What do you make of the U.S. presidential election?

The presumptive Republican nominee, Donald Trump, is an arch-pragmatist, despite making ideological noises. If Hillary Clinton wins and the Democrats retake Congress, then the U.S. is much closer to helicopter money.

What asset classes do you like?

U.S. 30-year bonds; Singapore government debt, which yields slightly more than U.S. government debt; gold; and Japanese equities hedged into the U.S. dollar. When helicopter money happens, every investor in Japan will ask, “What the hell am I doing holding bonds?”

You founded the Library of Mistakes. What are some of the big ones being made in finance?

Many mistakes reflect overconfidence. The biggest financial mistakes are ones that bring down whole banking systems. We just had one built on the belief that U.S. residential property could never come down. The biggest mistake today is so-called macro-prudential regulation. For example, the U.K. just passed a law that will restrict a commercial bank’s ability to make mortgage loans based on the edict of the central bank. It is state intervention in the allocation of capital. It is capitalism with Chinese characteristics.

The job of a central banker is to set the price of money, and align the system to allocate credit and capital. Macro-prudential regulation is a return to the credit controls of Richard Nixon. Finally, in the U.S. today, there is the belief excessive leverage doesn’t matter because interest rates are so low. That isn’t true. The secret now is to degear, delever, and prepare for some bargains as things get cheaper. And if we get helicopter money, you have to reverse and regear.